Success of Aldi poses real threat to local retailers: UBS

Are investors underestimating the risk that German global supermarket chain Aldi will erode the profits of the country’s biggest retailers?

Stocks such as Woolworths and Wesfarmers (which owns Coles) have been mainstays of investors, who appreciate their ability to grow earnings regardless of the state of the economy. But a major study released by investment bank UBS this week highlights the success that the privately owned discount supermarket chain has enjoyed in penetrating the Australian market.

Aldi already generates turnover of more than $5 billion in its 340 or so local stores, and UBS expects that revenue will climb at a compound rate of 13 per cent to reach $9.3 billion over the next five years.

But its rise represents a big threat to its local listed rivals.

The UBS report says: “The impact to the majors [Coles, Woolworths and Metcash] is significant. Under UBS’s base case, we expect the impact by retailer to be $250 million to $350 million per annum."

According to UBS’s base case, Aldi’s rise could cost
Woolworths
about $352 million in lost sales each year by 2019, while
Coles
could suffer a $313 million reduction. The smaller
Metcash
(which runs the IGA chain) is likely to see annual sales fall by $236 million. UBS estimates Aldi’s growing market share will detract 64 basis points of growth from its key competitors – that is, if the market is growing at 4.5 per cent, this will translate to 3.9 per cent excluding Aldi. As a result, to meet current UBS estimates, the market will have to record a compound average growth of 5.2 per cent to the 2019 financial year.

Absence of lift

As the report notes, “supermarket growth in Australia is running at around 4.8 per cent per annum, suggesting in the absence of a lift in trade, risks exist to our Woolworths, Wesfarmers and Metcash forecasts".

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The report says Metcash (where UBS has a neutral rating and a price target of $2.75) has the most to lose.

“We estimate Aldi will detract 1.8 per cent from like for like per annum, with a decline greater in South Australia/West Australia.

“This will place further pressure on Metcash, and while UBS assumes ongoing share loss, we see downside risk [if] the transformation [is] unsuccessful."

As for Coles (which is owned by Wesfarmers, which UBS rates as “neutral", with a price target of $43.20), the report argues that the impact of Aldi has been less pronounced given the turnaround in the retailer’s operations.

“However, with sales per square metre now on par with Woolworths, we expect the impact to Coles to be greater going forward. We estimate Aldi will detract 1.2 per cent from like for like per annum."

The pick of the bunch

Woolworths (which UBS rates as a “buy", with a price target of $39.20) is UBS’s preferred stock in the sector.

“While Woolworths is not immune and has been hit hard by Aldi since 2010, a rejuvenated offer, improved marketing and better use of data leave us of the view the impact to Woolworths will be less pronounced. We estimate Aldi will detract 1.1 per cent from like for like per annum."

“If they were to reverse penetration and penetration via strengthening their offer, we estimate more than $100 million of sales per annum could be added to Coles and Woolworths sales respectively." the report adds.

UBS analyst
Ben Gilbert
, who compiled the report, says it makes little sense for the major local retailers to slash prices to boost sales.

It’s difficult to compete on price with Aldi, he adds.

“The reality is that consumers see a lot of their brands as equivalent to the branded products but when the big retailers such as Woolworths and Coles compete on price through their private label brands, consumers don’t see these as equivalent to branded products. “The risk for the big retailers is that if they start to compete on price, it can become a downward spiral – a type of race to the bottom.“Instead, they need to try to engage the consumer on a wider value proposition that covers service and quality and a broader product range."

Gilbert points out that a UBS survey of attitudes to Woolworths published earlier this month revealed that fund managers expect that Woolworths – which enjoys margins that are among the highest in the world and well ahead of the global average for retailers – will see its margins flatten over the next five years. In contrast, the market expects that Coles’s margins will continue to rise as a result of continuing cost cuts and a change in the product mix.

But Gilbert argues that Woolworths has the potential to boost its margins by lifting its private label penetration, selling more fresh and general produce and continuing to take costs out of the business.